University of Saskatchewan Evaluation I PDF

Fall 2024 Evaluation I Tate N. Cao Ron and Jane Graham School of Professional Development As we gather here today, we acknowledge we are on treaty 6 Territory and the Homeland of the Metis. We pay o...

Fall 2024 Evaluation I Tate N. Cao Ron and Jane Graham School of Professional Development As we gather here today, we acknowledge we are on treaty 6 Territory and the Homeland of the Metis. We pay our respect to the First Nations and Metis ancestors of this place and reaffirm our relationship with one another. Today Define the Present Value and Future Value criteria Use these criteria to choose between alternatives Apply Payback Period method of analysis 2 Module 3 - Evaluation Apply the concept of economic equivalence to compare engineering alternatives Understand the limits and benefits of different evaluation methods Apply these methods to evaluate projects from private and public sectors 3 Solar, Wind, Bio-Fuel, or SMR? 4 Project Evaluation Companies need to make decisions Choose among products, projects, etc. Economic considerations weigh in Profitability matters! Decisions are complicated due uncertainty & risk Project cash flow economic calculations are similar to loan or mortgage cash flows. receipts (revenues, income, etc. – positive “+”) disbursements (expenses, wages, etc. – negative “-”) 5 Assumption of Engineering Economics End of Period Convention All cash flows are calculated as amounts at the end of period: Now = end of period 0 (beginning of period 1) Future amounts happen at the end of period specified. No Sunk Costs Only current situation and potential future are considered Two viewpoints Need to distinguish between investor and borrower Conventional assumption: required money is obtained at interest rate 𝑖 6 Relations Among Projects (3 Types) Independent - unrelated investment opportunities. Their economic attractiveness can be measured without reference to any other projects. Decision: consider each opportunity one at time and accept or reject it on its own merits. Buying a laptop and buying a microwave Mutually exclusive - If choosing one project automatically results in rejecting all other projects, i.e. it is impossible to do both. Decision: consider the most suitable Buying a laser printer or an inkjet printer Related but not mutually exclusive – the expected costs and benefits of one project depend on whether the other project is chosen. Building charging station at location 1 and location 2. Decision: 4 possibilities Do nothing Just location 1 Just location 2 Both locations 7 What is Your Decision Criteria? For economics domain: How quickly can I recover my cost? How much profit can I make? How quickly and how much can I make? … What are non-economic considerations? Ethics Environmental? Societal? … Cash Flow: $million +15 +7 +5 0 1 2 3 4 Time: -10 -5 Year 8 Evaluation Methods Focus on liquidity Payback Method Focus on a firm Net Present Value Net Future Value Capitalized Equivalent Annual Equivalent Value Internal Rate of Return Focus on the public Cost Benefit Ratio 9 The Payback Period Method The payback period is the length of time it takes to recover the cost of the initial investment. (i. e. the sooner to recover the better) Method: All costs and benefits are included without differences in their timing All economic consequences beyond the payback period are ignored Example: ABC Corporation has a payback period requirement of 3 years or less on all projects. Should ABC accept the project below? Investment -100 100 𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 = = 𝟒 𝒚𝒆𝒂𝒓𝒔 25 Annual Revenue for 5 years 25 10 The Payback Period Rule Advantages Shortcomings Easy to use and understand It ignores the time value of money Biased towards liquidity Cutoff point is arbitrary Adjusts for uncertainty of later Ignores cash flows beyond the cash flows…by completely payback period ignoring them! Biased towards short term projects 11 Discounted Payback Period (DPBP) What if the capital used are borrowed? We can consider the time value of money by discounting the predicted future cash flow Calculate and sum the Present Value of each of the yearly cash flows The discounted payback period is the number of years to recover the investment from the discounted cash flows (DCF) Need an interest rate (discount rate) The Shorter the DPBP the better 12 Example 1 - Discounted Payback Consider the 2 scenarios with a discount rate of 10% per year. Which one should we pick based on Payback Period and Discount Payback Period? Do they agree with each other? Project A Project B 0 (200,000) (200,000) 1 50,000 50,000 2 50,000 70,000 3 50,000 80,000 4 50,000 4,000 5 50,000 3,000 6 50,000 1,000 Note: In economics and finance related disciplines, the negative/ outgoing cash flows are labeled often in parentheses “()” or colored in red, instead of “-” 13 Example 1 – Solution Payback Period N Project A Cumulative Cash Flow Project B Cumulative Cash Flow for Project A for Project B 0 -200,000 -200,000 -200,000 -200,000 1 50,000 -150,000 50,000 -150,000 2 50,000 -100,000 70,000 -80,000 3 50,000 -50,000 80,000 0 4 50,000 0 4,000 4,000 5 50,000 50,000 3,000 7,000 6 50,000 100,000 1,000 8,000 14 Example 1 – Solution DPBP Cumulative Cumulative Discounted Discounted N Project A Cash Flow for Project B Cash Flow for Cash Flow Cash Flow Project A Project B 0 -200,000 -200,000 -200,000 -200,000 -200,000 -200,000 1 50,000 45,455 -154,545 50,000 45,455 -154,545 2 50,000 41,322 -113,223 70,000 57,851 -96,694 3 50,000 37,566 -75,657 80,000 60,105 -36,589 4 50,000 34,151 -41,507 4,000 2,732 -33,857 5 50,000 31,046 -10,461 3,000 1,863 -31,994 6 50,000 28,224 17,763 1,000 564 -31,430 15 Net Present Value (NPV) The difference between an investment’s initial cost and the sum of all discounted future cash flows is called the Net Present Value (NPV) or Net Present Worth (NPW). Key criteria: how much profit(value) is created in today’s dollars compare to today’s investment. Assume the projects have equal time periods. The alternative with the higher NPV or NPW is selected 𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒=𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 (𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) −𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 (𝐶𝑜𝑠𝑡𝑠) Situation Rule Fixed Input Maximize Output Fixed Output Minimize Input Neither Input or Output Maximize (Output-Input) Fixed 16 Net Present Value (NPV) The alternative with the higher NPW or NPV is selected. NPW or NPV must be a POSITIVE value to make the project desirable. NEGATIVE NPV means you are going to pay for a project out-of-pocket Discount Rate The discount rate chosen is often called MARR (Minimum Acceptable/ Attractive Rate of Return) MARR must exceed the weighted average cost of capital (WACC) and the rate of return of the opportunity cost (options for investing) 17 Key assumptions Cash flows occur at time 0 and at the ends of of periods 1 through N Cash flows are known, the horizon, N, is known, and there is no uncertainty The interest rate, 𝑖*, for the time value of money is known hurdle rate *minimal acceptable rate of return (MARR), is also called hurdle rate. MARR should cover at least the cost of capital of the firm, which is often WACC measured by WACC. It often will account the level of risk as well. MARR=WACC + Risk Premium *It might favor projects have higher rate of return but smaller dollar value. 18 Example 2 - NPV The NEW company needs a piece of equipment for their factory. The machine needs to run for 5 years. There are 2 models with cash flows as follows: Model I: costing $15,000, with profits of $5,000/year. Model II: costing $20,000, with profits of $6,500/year. The company has a MARR of 10%. Which model of the machine should the company choose? 19 Example 2 - Solution The problem illustrates a decision on equipment selection, using NPV selection: 𝑁𝑃𝑉 = 𝑃𝑉 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑃𝑉(𝑃𝑟𝑜𝑓𝑖𝑡) Model I: 𝑁𝑃𝑉𝐼 = −15,000 + 5,000 𝑃/𝐴, 10%, 5 = $ 3,953.93 Model II: 𝑁𝑃𝑉𝐼𝐼 = −20,000 + 6,500 𝑃/𝐴, 10%, 5 = $ 4,640.11 Model II share be Chosen (greater value) 20 Capitalized Equivalent Method In governmental analysis, a service such as roads, dams, pipelines should be considered permanent. The analysis for these situations would have an infinite analysis period (𝑛 = ∞). Process of computing the PV of the infinite series is known as the capitalization of the project costs Capitalized cost: the present sum of money that would need to be set aside now, at some interest rate, to yield the funds required to provide the service (or what we need) indefinitely. 𝐴 Capitalized cost: 𝑃 = 𝑖 21 Example 3 - Capitalized Cost An alumnus of the university wants to set up an annual scholarship. The proposed scholarship is going to be $5,000 a year for ‘forever’*. How much money will he have to put into an account today, with an interest rate of 4% compounded annually, so that there will be enough money in the account to pay the scholarship every year? *Perpetuity: an annuity that has no end, or a stream of cash payments that continues forever. 22 Example 3 - Solution In this case, the annuity last forever, therefore we treat 𝑛 = ∞ 𝐴 = $5, 000 𝑖 = 4% 𝐴 5,000 𝑃= = = $ 125, 000 𝑖 4% This capitalized fund is also called endowment in this case 23 Take 2 mins to Organize Your Notes Method How to Use it When to Use it Advantages Disadvantages Payback Period Discounted Payback Period NPV Capitalized Cost 24 Future Value Analysis Need to know the situation of set of alternatives at any point in time in future Very similar to present value analysis but analysis exists at some future point in time For example, what is amount of retirement saving will I have in 20 years? Key Assumptions: As in present value analysis, evaluation must be over same time period The same criteria are used and the same process with NPV 25 Example 4 – Future Value Analysis A firm has decided to establish a second plant. There is a factory for sale that with extensive remodeling could be used. As an alternative, the company could buy vacant land and have a new plant constructed there. The timing and cost of the various cash flows are as follows: New Plant Remodel Year Component Cost Component Cost 0 Land $ 85,000 Purchase $850,000 Factory 1 Design & Initial 200,000 Design & 250,000 Cost Remodel 2 Balance of 1,200,000 Remodel 250,000 Construction 3 Production 200,000 Production 250,000 Equipment Equipment If interest is 8%, which of the two alternatives should be selected? 26 Example 4 – Solution New Plant: 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝑜𝑠𝑡 = 85,000 𝐹/𝑃, 8%, 3 + 200,000 𝐹/𝐴, 8%, 3 + 1,000,000(𝐹/ 𝑃, 8%, 1) 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝑜𝑠𝑡 = $ 1,836,355 (1,836,300 using interest table) Remodel: 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝑜𝑠𝑡 = 850,000 𝐹/𝑃, 8%, 3 + 250,000 𝐹/𝐴, 8%, 3 𝐹𝑢𝑡𝑢𝑟𝑒 𝐶𝑜𝑠𝑡 = $ 1,882,355 (1,882,500 using interest table) The new plant is projected to have smaller future cost and thus is the preferred alternative. 27 Example 4 – Solution (NPV) New Plant: 𝑁𝑃𝐶 = 85,000 + 200,000 𝑃/𝐴, 8%, 3 + 1,000,000(𝑃/𝐹, 8%, 2) 𝑁𝑃𝐶 = $ 1,457,758 (1,457,700 using Interest Table Remodel: 𝑁𝑃𝐶 = 850,000 + 250,000 𝑃/𝐴, 8%, 3 𝑁𝑃𝐶 = $ 1,494,274 (1,494,250 using Interest Table) The new plant is projected to have smaller net present value (cost) and thus is the preferred alternative. 28 Summary Must Know: Calculate the payback period and use it to assess the desirability of a project Distinguish between independent and mutually exclusive projects. Calculate which independent or mutually exclusive projects should be approved using either net present value (NPV) or net future value (NFV) Calculate present value for project with infinite analysis period using Capitalized Cost method. Understand what is a minimum acceptable rate of return Nice to Know: Understand how to select a minimum acceptable rate of return (MARR) Understand the decision sets for related but not mutually exclusive projects. 29 Practice Question Walt Wallace Construction Enterprises is investigating the purchase of a new dump truck with a 10-year life. Interest is 9%. The cash flows for two likely models are as follows First Cost Annual Cost Annual Income Salvage A 50,000 2,000 9,500 10,000 B 80,000 1,000 12,000 30,000 Which project should you pick using payback period? Which project should you pick using NPV method? Do they agree to each other? 30